What it means
Short sellers borrow shares, sell them and hope to buy them back more cheaply later. The worry behind the uptick rule was that heavy short selling into a falling market could push prices down further and faster, creating a spiral that has little to do with the underlying business.
The rule was designed to make short sellers wait for the price to tick up before they could add to the pressure. The original rule was set by the US Securities and Exchange Commission (SEC), the main markets regulator in the United States, and it stayed in place for roughly seven decades.
It was removed in 2007 after the regulator concluded that it no longer served its purpose in modern, electronic and rapidly traded markets. After the financial crisis of 2008, pressure grew to bring something back.
The replacement, known as Rule 201 or the alternative uptick rule, was adopted in 2010. It works as a circuit breaker, meaning it only switches on when a stock falls 10% or more from the previous day's closing price.
Once triggered, short sales in that stock are restricted for the rest of that trading day and for the whole of the next day. While the restriction is active, a short sale may only be placed at a price above the current best bid, which is the highest price any buyer is currently offering.
That prevents short sellers from hitting the bid and driving the price lower, but it does not ban short selling altogether. Traders can still sell short at a higher price, and long holders can still sell as normal.
For a non-finance manager, the practical relevance is in reading market news and understanding why a stock may behave differently after a bad day. Investor relations teams, treasurers with employee share plans and anyone holding shares in a listed business should know that a sharp drop can trigger these trading limits.
The rule is aimed at orderly markets rather than at protecting any particular company.
In practice
Real-world examples.
Example
A retail technology stock closes at $50.00 and drops to $44.00 after a weak sales update. Because $44.00 is below the $45.00 trigger, the alternative uptick rule applies for the rest of the day and all of the next day. Short sellers can only sell at prices above the best bid.
Example
A hedge fund analyst expects a pharmaceutical company's trial results to disappoint. After a sharp fall on rumours, the fund finds it cannot hit the bid to add to its short position. It must wait for buyers to push the price up before it can sell more.
Example
A founder with listed shares in a small energy company watches the price fall 12% in one morning. Her broker explains that short selling is now restricted in the stock until the following day closes. She uses that breathing space to talk with her investor relations adviser about what to tell the market.
Formula
Calculation
Trigger price = previous day's closing price x (1 - 0.10)
Suppose a listed company closed yesterday at $80.00 per share. The trigger price is 80.00 x 0.90 = $72.00. If the share trades at $72.00 or lower at any point during today's session, the circuit breaker switches on. From that moment, a short sale is only allowed at a price above the current best bid. If the best bid is $71.50, a short seller must offer at $71.51 or higher, and the restriction continues through the whole of tomorrow's session as well.Case study
Seen in the real world.
Kestrel Brightworks is an illustrative, fictional solar equipment maker listed on a US exchange. One morning a rival announces a cheaper product, and Kestrel's shares fall from $40.00 to $35.50 within two hours, a drop of more than 11% from the previous close.
The company's finance director sees that the trigger price of $36.00 has been crossed and the short sale restriction is active. She expects fewer aggressive short sales over the next two sessions, and decides to hold an investor call on the second day, when the price is less likely to be pushed down by fast selling.
In this illustrative story the share price steadies at $36.80 once the call has taken place. The finance director learns that the rule does not protect the price from genuine bad news, but it can remove some of the panic-driven pressure that follows it.
Watch out
Common mistakes.
- Believing the uptick rule bans short selling, when it only limits the price at which a short sale can be made after a large fall.
- Assuming the original 1938 rule is still in force, when it was removed in 2007 and replaced by a narrower rule in 2010.
- Thinking the restriction protects the price from falling, when its aim is to slow short-selling pressure rather than prevent a fall driven by bad news.
Questions
People also ask.
Does the uptick rule apply to every stock all the time?
No, the alternative rule only switches on for a stock after it falls 10% or more from the previous close in one day, and it then lasts for the rest of that day and the next one.
Who sets the uptick rule?
The US Securities and Exchange Commission adopted both the original rule and the alternative version, and other countries set their own short selling rules separately.
Can ordinary investors still sell their shares during the restriction?
Yes, the limit only affects short sales, so people selling shares they already own can trade as normal.
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